Incorporation relief in a nutshell
The transfer of business assets by an individual to a company controlled by them is a disposal for capital gains tax purposes. The disposal is deemed to take place at market value because the sole trader and the company are connected. The individual will therefore incur a capital gain on the chargeable assets at the point of incorporation. The assets most likely to generate a capital gain are land and buildings and goodwill. It is possible to defer the gain through incorporation relief.
The relief is available for qualifying incorporations and this overview gives brief details of the qualifying conditions.
What transactions qualify for incorporation relief?
To be eligible for incorporation relief a business must be a going concern and all assets of the business (apart from cash) must be transferred to the company. The amount paid to the individual by the company for the assets must be partly or wholly in the form of shares.
How is incorporation relief calculated?
The relief is calculated by taking the total capital gains on the transfer of the assets and multiplying this total by the value of the shares received divided by the total consideration. This gives the amount of incorporation relief which is deducted from the total gains to leave any remaining gain arising on incorporation chargeable. Having a gain left in charge could perhaps be because the consideration provided by the company was only partly in shares.
Incorporation relief is a deferral relief, so the amount of the deferred gain is deducted from the base cost of the shares in the company. The deferred gain will therefore be chargeable when the shares are subsequently sold.
Incorporation relief is automatic and no formal claim is necessary. It is not possible for the individual to restrict incorporation relief in order to make sure the capital gains tax annual exemption is utilised. However, it is possible for the individual to take a specific amount of loan stock to generate a gain equal to the annual exemption.
When will it be beneficial to claim incorporation relief?
Where a partnership or a sole trader's business is to be acquired by a company, it is common practice first to transfer the business to a newly formed company in consideration for shares, claiming incorporation relief. The shares are then the subject of a ‘share for share' acquisition by the ultimate purchasing company, so that tax on the capital gain is deferred.
The relief may also be used where a sole trader or partnership wishes to dispose of an asset standing at a substantial capital gain; the business may be incorporated, obtaining incorporation relief, so as to increase the base value of the asset for capital gains purposes before the newly incorporated company sells it.
When may it not be beneficial to claim incorporation relief?
Incorporation relief is automatic, if the qualifying conditions are met, but an individual can elect for the relief not to be applied. This will be a consideration for individuals who have not utilised their full business asset disposal relief limit, and particularly where they do not expect to be able to benefit from business asset disposal relief on a subsequent disposal of the shares in the company because they do not anticipate meeting the qualifying conditions at that later date.
Is there an alternative to incorporation relief?
If an individual gifts a business asset, the donor and the donee can make a joint election to defer the gain under the gift relief provisions. Gift relief can therefore be used as an alternative to incorporation relief where a sole trader transfers the business to a company at undervalue and this is usually regarded as the simplest approach.